This week, CBA launched a new bank hybrid hot on the heels of Westpac's new issue, which has us questioning: are hybrids any better than bank shares? We think both will react similarly in a downturn but hybrids are more complex
As published in The Australian on 10 March 2018
Australian investors love bank shares for the income they provide.
Market commentators have called them income stocks and even “bond proxies”, but investors should never think of shares as bonds because they don’t have the same protections - a maturity date and defined income.
Retail investors in recent years have been particularly attracted to bank hybrids, which feature a mix of bond and share characteristics but over time have evolved to become much more like shares.
With some new hybrids in the market from CBA and Westpac it’s a good time to ask: are hybrids any better than shares which are still yielding very healthy yields?
Remember share prices have been fairly flat over the last ten years, not attractive to those looking to grow capital but have generated consistent, relatively high income. For example, NAB’s dividend of 99 cents per share hasn’t changed in the last four years, providing similar and, some may argue, better consistency than floating rate hybrids where income is adjusted quarterly based on an underlying benchmark.
The current dividend yield for the ‘big four’ banks ranges between 5.72 and 6.67 percent excluding franking. The latest Westpac hybrid yields about 5 per cent including franking, the overall difference in yield depends on your individual tax rate.
Hybrid income is paid quarterly, better for those wanting the cash flow compared to half yearly for the shares.
Dividends can be cut or not paid at all. While hybrid distributions can also be foregone like shares, although this is unlikely.
In turn, hybrid investors can expect to have capital returned at the call date, subject to certain conditions and approval of APRA, the regulator. The new Westpac WBCPH has a first call in September 2025 – circa 7.5 years. If Westpac fails to meet the requirements for mandatory conversion two years later in 2027, the hybrid becomes perpetual.
It’s worth noting that conversion conditions are complex and involve the average of the daily volume weighted average sales prices of the shares leading up to the conversion date.
If you think about it, many new hybrid issues are to refinance existing ones. Investors are even buying up hybrids due to be called to get a foot in the door for the next issue. So, if you keep agreeing to reinvest, even though there is a call date, hybrids can be ongoing investments, similar to the shares.
I would also add there is little diversification benefit if you already own the shares. Australians already overweight on banks, increase portfolio concentration by adding bank hybrids.
Certainly expected volatility over the life of the hybrid is lower. Prices will fall in a correction, and in a severe correction like the GFC, hybrid prices fell by about 30 per cent, around half that of the shares. That’s a benefit.
But hybrids are far more complex than the shares. Investors must understand all of the terms used to describe them - fully paid, non-cumulative, convertible, transferable, redeemable, subordinated, perpetual, unsecured notes subject to capital and non-viability triggers.
(1) Shareholders can benefit from special dividends and share buy backs; there is no upside for hybrid investors to these actions.
(2) In the unlikely worse-case scenario, hybrids convert to shares to support the ‘survivability of the bank’. They carry the same ultimate downside risk.
When assessing hybrids, returns should not be compared to bank deposits, but to bank shares, given the similarities. Government guaranteed term deposits offer a set maturity date and defined income.
New issues and relative value
This week, CBA launched a new bank hybrid the Perls X, hot on the heels of the new Westpac WBCPH issued last month.
The Perls X, like the WBCPH, aims to raise the standard $750m, but if it is anything like the Westpac issue will be significantly oversubscribed – Westpac accepted $1.45 billion.
What is interesting is the premium CBA are willing to pay over the oversubscribed Westpac issue with the quoted yield from 340 to 360 basis points over the three month bank bill swap rate, at least 20 basis points more than the WBCPH. Why?
Is CBA concerned that the Westpac issue has taken some of the demand out of the market? So, it needs to offer a higher rate? Unlikely, there is still plenty of cash looking for higher yields. Has the bank learned from the past Perls VII issue, where it issued at the lowest margin in recent history of 280 basis points and the hybrid has consistently traded below its face value? … Or is it sick of negative publicity?
The other possibility is that the Westpac issue margin was too low relative to existing securities. If you ever want to check the relative value of hybrids, have a look at YieldReport.com.au. They publish weekly trading margins for hybrids. The most recent graph shows the going margin for hybrids with similar call dates as higher than the new Westpac issue at around 350 basis points. This makes the WBCPH issue look expensive. Maybe it’s time for hybrid investors to exit and bid on the Perls X?
The similarity of bank shares and hybrids mean they will react similarly in a downturn. The relative value between bank shares and hybrids will change given the yields available and your capacity to claim franking credits. In any event, there is a case for preferring the simplicity of the share over the more complex hybrid.